Are US Bank Loans Really Growing?

As we head into the Q2 ’18 earnings conversation, a couple of early earnings releases suggest that loan growth may actually be increasing even as the Federal Open Market is shrinking the funding base. This is a peculiar idea that comes from the world of Keynesian economics, which positively associates lending and GDP growth. In fact, loan growth is linked to deposit growth and earnings growth is linked to, you guessed it, taxes.

Loan growth is good, but when your deposit base is shrinking, the uptick can only last so long. Let’s ponder some examples. The folks at Bank of the Ozarks (OZRK) announced that net income for the second quarter of 2018 was $114.8 million, a 26.8% increase from the second quarter of 2017. Diluted earnings per common share for the second quarter of 2018 were $0.89, a 21.9% increase from the second quarter of 2017. Thank you Donald Trump.

Part of these good results is due to the 2017 tax cuts, but OZRK also is an outlier in the US banking industry – in a good way. In fact, one of the reasons that regional banks as a group have outperformed the big banks in recent months is that they are growing credit and are thus creating shareholder value apart from the mechanics of lower tax rates.

OZRK’s annualized returns on average assets, average common stockholders’ equity and average tangible common stockholders’ equity for the second quarter of 2018 were 2.10%, 12.90% and 16.08%, respectively, compared to 1.90%, 12.05% and 15.81%, respectively, for the second quarter of 2017. That’s performance that puts this $20 billion bank in the top decile of the entire US banking industry.

I interviewed OZRK CEO George Gleason last August, when he got to brag about his strong credit metrics and overall operating efficiency (35%). A lot of hedge funds have lost a lot of money shorting George’s stock. But the reason I like to follow this Little Rock, AK, lender is that OZRK has a national commercial real estate (CRE) and commercial and industrial (C&I) lending business.

Other banks buy participations in OZRK loans, or sell loans to the bank, in part because they trust OZRK’s credit judgment and ability to manage credit risk through time. If OZRK is growing, there is a good chance that the industry is expanding these asset classes as well. Of note, while OZRK did see a double digit increase in total loans in Q1 ‘18, it has paired back purchases of loans significantly. With 7bp of gross defaults in Q1 ’18, OZRK is well-below peer in terms of credit losses.

Then we have $24 billion Commerce Bancshares in Kansas City (CBSH). Like OZRK, CBSH has seen a 20-30bp increase in asset and equity returns as a result of the 2017 tax cuts. Analyst note, December 2017 is a structural inflection point that separates previous asset and equity return data from the going forward bank performance metrics.

For the quarter, CBSH return on average assets was 1.80%, the return on average common equity was 16.8%, and the efficiency ratio was 54.1%. In 2017, asset returns were 1.17%, so the tax bill added almost half a point to CBSH’s asset and equity return metrics. The 115 member Peer Group 1 set by the FFIEC moved from 0.9% ROA in 2017 to 1.17% in Q1 ’18. Magic!

CBSH saw it’s loan portfolio mostly flat, with growth in CRE, mortgage and C&I lending, but a large sale of auto loans to another bank. Hmmm.... Like most US banks, current credit costs continue to fall even as the crowd of people worried about future credit grows. Non-performing assets at CBSH declined to $10.5 million, while the provision for loan losses matched net loan charge-offs and the allowance for loan losses amounted to $159.5 million, or 1.14% of period end loans.

Neither OZRK nor CBSH is likely to push their loan portfolios as a percentage of assets much above current levels, so I'd fade the lending growth narrative. Some outliers like OZRK may continue to drive loan growth, but the secular trend in both deposits and loan balances has been negative since 2016, which was the near term lending peak. As the FOMC runs off its portfolio and necessarily destroys system reserves in the process, the raw material for lending will likewise diminish.

So is bank loan growth headed higher in Q2 ’18? Maybe. Is loan growth likely to rise for the rest of ’18? Nope. And the simple reason has nothing to do with Keynesian pretentions about credit expansion and GDP, but everything to do with the FOMC shrinking excess reserves and, with it, bank deposits.